DABERIAM XLIV

November 2008

The breakdown of the banking system is still “work in progress”. The fact that it has not been fixed is serious. While it appears unlikely that after the Lehman experience Governments will let any more large or even mid-size banks go down, the bankers themselves are not performing their function of providing liquidity to commerce and industry. 

There is a continuing deterioration in the availability of trade finance leading to a rapid decline in commercial transactions around the world. This can be most easily seen in the decline in shipping rates, which are now down by over two-thirds, and indeed below the cost of running the ships concerned. The dislocation in the supply chain could easily lead to the destruction of many industries, leading to a severe recession. 

By the end of October, the financial system had virtually stalled and I am now less sanguine as the situation is still deteriorating. While Obama is making intelligent plans and has put in place a first class economic team, he will probably not be in a position to act until January next year. Europe is still presenting a confused front. With the German Chancellor in a “let’s not be too hasty to act” mode on one side, and the Mediterannean countries pleading for concerted European action on the other.

China, on the other hand, is beginning to move in a deliberate and analytical way but is probably grappling with a cyclical economic downturn, being compounded by the global economic crisis. Japan, which has hardly managed to recover from its 1990’s recession, is sliding backwards as the world demand for its exports collapses.

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 28 November 2008	USD	1.00%	EUR	3.75%	GBP	4.50%
MSCI World Equity Index	31/10/2008	192.11	31/12/2007	299.916	YTD %	-35.95%
Gold (PM London Fix $ per ounce)	31/10/2008	730.75	28/12/2007	833.75	YTD %	-12.35%
Oil (WTI Crude $ per barrel)	31/10/2008	67.81	28/12/2007	96.01	YTD %	-29.37%

This leaves the bizarre case of Britain where the Prime Minister, having spent the last five or six years talking prudence and running a profligate Government, intervenes periodically in his Darling Chancellor’s efforts to resolve the economic crisis by vetoing the few sensible suggestions that are put up. There is a systematic failure in Government policy making caused by Brown’s dismemberment of the authority of the Bank of England, the only body that had some understanding of the banking system. When regulation of the system was split between the Bank, the FSA and the Treasury and the management of Government debt was parked in a backwater, the ability to create cohesive advice for the Chancellor was destroyed. There are now four key areas with different remits and responsibilities and the Chancellor seems to be unable to get a cohesive and thoughtful policy developed, the underlapping departments make it almost impossible to produce an analysis of the extremely complex problems that are causing the economy to unravel.

The latest policy initiative of reducing VAT by a few percent will have no impact on people’s purchase decisions, particularly as the retail sector is embarking on massive discounting on sales, while the increase to UK industry and other employers of National Insurance, as well as the increase in tax on fuel, which will affect distribution costs, is negative for employment. Added to this the ballooning Government deficit will almost inevitably lead to interest rate rises one to two years from now. Add to this the pre-announcement that taxes will rise considerably in 2010 is a statement calculated to kill off any potential green shoots that may be appearing at the end of 2009. 

The leaks accompanying the announcement indicate that it was a decision to make a grand statement before the cohesive and intelligent policy was thought through, showing we still have a UK Government that is addicted to spin over substance. 

Most statistics are showing a precipitous decline in business akin to the 1981 recession, which was the worst recession in recent history. The difference between then and now is that today it is the breakdown in the interbank system that has precipitated the crisis, and the danger to countries that are most dependent on world trade is much greater if this dislocation is not fixed in the near future. 

It is the breakdown of world trade that gives me the greatest worry, but it is also the observation that the US is less dependent than most countries on international trade that gives me some hope. It is to the US that we need to look for the light at the end of this tunnel, which we may have only just entered.

Damon de Laszlo 
November 2008

DABERIAM XLIII

October 2008

When I last put pen to paper in August, I was expecting economic deterioration and that “the pessimism was likely to continue to grow”. I was also thinking that “we seem to be getting near to the bottom of an economic downturn”. 

It is difficult to remember all the individual events since August, but one only needs to observe the result was the total unravelling of the banking system around the world as the financial institutions ceased to trust each other. Individual people, not surprisingly, took their lead from the publicity surrounding this breakdown of trust and decided to panic, i.e., sell their stocks and shares, mutual fund holdings and anything else that was negotiable. 

Churchill once observed that, the American Government can always be trusted to do the right thing - after it has exhausted all other options. This wartime comment could be applied today to all the Governments of the Western world. The crisis has probably peaked in October ’08 which hopefully is the turning point. The leaders of the Governments around the world met to take concerted action outside the regulatory systems and to throw the weight of Government guarantees behind the financial institutions. 

Many books will be written and few lessons learned. It is sufficient to observe that continuing periods of time during which nothing goes wrong encourage complacency and forgetfulness about risk. During such periods, bureaucracy is encouraged to do what it does best - covering the system in form filling and box ticking. Bureaucracy by its very nature suppresses or avoids imagination. This allows imaginative institutions, i.e., the private sector to develop in an evolutionary fashion by working and taking advantage of areas of least resistance.

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 30 September 2008	USD	2.00%	EUR	4.25%	GBP	5.00%
MSCI World Equity Index	30/09/2008	232.793	31/12/2007	299.916	YTD %	-22.38%
Gold (PM London Fix $ per ounce)	30/09/2008	884.50	28/12/2007	833.75	YTD %	6.09%
Oil (WTI Crude $ per barrel)	30/09/2008	100.64	28/12/2007	96.01	YTD %	4.82%

It is worth quoting from the FT, 18 October: Lord Turner, the new Chairman of the UK’s Financial Services Authority, protests that supervision on the cheap explains the FSA’s failure to flag the risks in the landscape of British banking - his solution is pushing for higher regulatory fees! 

The problem with systems and formulae, from the hard equations of physics to the rather abstruse equations of economics, is that practitioners forget that they all have parameters outside of which they do not function. The risk assessments made within the financial systems of the world make no allowances for the famous black swan that Tabel used to illustrate the highly improbable event. 

In a short note such as this, it is not worth listing the dozens of failures of the regulatory systems that, coupled with the linear extrapolation of ever increasing prosperity from a spiralling debt phenomenon, led to the collapse of the exciting innovations of the last few years. 

The explosion of lending to individuals became circular as property prices were bid up, creating huge amounts of liquidity, fanned the flames of asset inflation primarily in property and commodities. The rising inflation encouraged Central Banks to raise interest rates and choke off liquidity, which combined with changes in some fundamental accounting and regulatory practices produced this black swan event. 

Timing of the collapse by definition was difficult to predict and the collapse and its ramifications are greater than predicted as the whole system has failed, rather than the more expected and less violent descent into a conventional recession. The question to address is, what is the likely rational outcome of an irrational event? 

A lesson I learned from a cousin of mine who, after the crash of the 1930s, even though he was a banker, never bought Equities again and only held Government Stock - turning what was a relatively large fortune into a small one through the ravages of inflation by the time he died in the early eighties. 

Evolutionary theory tells us that life as we know it is likely to proceed but there will be new innovations bolted on to the old system. Habit and Government action will fix the system; the banking system is stuttering back into life and while world trade and commerce has been severely dented, it will recover. The halving of commodity prices, oil from $145 to $70 pbl, will effectively transfer hundreds of billions of dollars back to the consuming countries helping to repair national and personal balance sheets. While the destruction of possibly trillions of dollars of debt around the world will cause negative GDP growth. 

After the next six to nine months the economies around the world will return to a slower growth mode. At some unexpected point, stock markets are likely to recover rapidly as they anticipate the change from negative to positive GDP. 

The other interesting possible by-product of the crisis and the transfer of huge amounts of liquidity from the commodity producing countries, is the likely reduction in the flow of funds to terrorist organisations. To make a wild prediction, there may be a return of some frugality by the population in general and barring an event in the short term, a respite from global terrorism, at least until economic recovery starts again to push up oil and other commodity prices. 

The run up to Christmas is not going to be fun but next year has a silver lining!

Damon de Laszlo 
October 2008

DABERIAM XLII

August 2008

I have to admit, when I mentioned Russian sabre rattling last month, I had not anticipated the actual event happening so soon. Russia’s invasion of Georgia would appear to have been meticulously planned and only waiting for an appropriate occasion. The fascinating lesson from the whole exercise, however, was the muted response from the German Chancellor. She was clearly anxious not to offend Russia, conscious of the vulnerability of an “accident” to Germany’s energy supplies. The Russian lightning strike, and now withdrawal, further indicate the vulnerability of European energy supply as pipelines from the reserves around the Caspian Sea were over flown by Russian aircraft, although not damaged. This pipeline is currently out of action owing to it being sabotaged in Eastern Turkey. 

On the economic front, food and commodity prices would appear to have peaked as speculative liquidity has drained out of the various commodity markets. It seems that the new fashion for what used to be called ‘hot’ money is now to buy the structured investment vehicles that have wrought such havoc in the banking sector. In the short term, there is something of a silver lining in the events of the last few weeks - European energy policy may develop a more serious attitude towards supply and help the decision taking process that will enable the Nuclear programme to restart. The lack of energy security in Europe is probably the greatest threat to the European structure that we face. The power of the Misologists of the Green movement may just be beginning to wane. The other good news, the decline in commodity prices, is greatly reducing the Central Banks’ desire to raise interest rates which would certainly completely collapse the European economies. 

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 31 July 2008	USD	2.00%	EUR	4.25%	GBP	5.00%
MSCI World Equity Index	31/07/2008	280.137	31/12/2007	299.916	YTD %	-6.59%
Gold (PM London Fix $ per ounce)	31/07/2008	918.00	28/12/2007	833.75	YTD %	10.10%
Oil (WTI Crude $ per barrel)	31/07/2008	124.08	28/12/2007	96.01	YTD %	29.24%

On the global front, the US economy looks the strongest in the West going forward. Their imports are declining, exports rising and, apart from the now obvious problems in the finance and building sectors, the rest of the economy is looking far stronger than Europe. 

In Asia, the Chinese Government, once it is through the Olympics, will endeavour to reinvigorate the economy and get it back on track for a 10% growth rate. It has to be remembered that China’s policy is to add in excess of ten million jobs a year as it urbanises its agricultural population. 

The uncertainty and lack of direction from the US will continue until the new Administration settles in at the beginning of next year. It is worth remembering this is the most vulnerable time for the US from the point of view of some terrorist outrage. The deterioration in European economies and the pessimism is likely to continue to grow. The outlook is particularly bleak for those of us living in Britain, as our Socialist government, which has squandered the country’s resources over the last ten years, is now rudderless and bereft of any idea of what to do. 

While the above may sound pessimistic, I think one should draw some optimism from the fact we seem to be getting near the bottom of an economic downturn and the chances are that, looking a year ahead, one will be able to be more sanguine about the future, at lest outside Europe.

Damon de Laszlo 
August 2008

DABERIAM XLI

July 2008

As we are now in the second half of 2008, it is time to raise our sights to 2009. The unwinding of the debt crisis is likely to continue through the end of ’09 as the problems in the banking sector continue to accumulate. The psychological momentum will by the year-end have gone from denial by most economists and regulators that we were heading into economic problems last year, to extrapolating endless gloom and disaster going into ’09. 

The debt crisis will next year have a very depressing effect on economic growth as the West’s banking system increasingly becomes short of liquidity. The impact will be most painful in Europe as there is hardly any room for Government intervention when compared with the USA. The dollar area also has the advantage that it is the only place that the Sovereign wealth funds etc. of the Middle East and Asia can easily invest.

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 30 June 2008	USD	2.00%	EUR	4.00%	GBP	5.00%
MSCI World Equity Index	30/06/2008	324.671	31/12/2007	299.916	YTD %	8.25%
Gold (PM London Fix $ per ounce)	30/06/2008	930.25	28/12/2007	833.75	YTD %	11.57%
Oil (WTI Crude $ per barrel)	30/06/2008	140.00	28/12/2007	96.01	YTD %	45.82%

The USA will also benefit, perversely, from the high price of oil over the next 12 months or so. The appreciating RMB against the dollar and the huge increase in freight rates is starting to have an increasingly beneficial impact on the US terms of trade and the US domestic economy. One can expect that US industry will provide a growing percentage of the US GDP as it gears up to support the domestic market, replacing Asian sources and increases its exports to the rest of the world. It is interesting that both BMW and Toyota have recently announced planned increases in their motor-car production in the US. 

The global increase in commodity prices, coupled with China’s growing impact on the global economy as it ceases to be the provider of low cost consumer goods to the West, means we can expect rising inflation for some time to come. However, it is probably unlikely to take hold in the same way as it did in the 70s. The Western economies, particularly the USA, are unlikely to see rampant wage increases as the labour markets in general are not tight. 

There is, however, a considerable shortage of skills as there has been a dumbing down of education in most countries over the last ten years or so. The wildcard on inflation is nevertheless commodity prices. We can assume that food production will increase over the next year or so as the price incentive takes hold. Similarly, oil production will increase as the new found wealth of the producers start to get absorbed and they look for more. The recent rapid rise in price has in the short term had the strange effect of discouraging many producers from increasing production as the same amount of oil produced so much more cash. 

One can expect this phenomenon to change next year, even countries like Russia will wake up to the fact that their new revenue streams will decline if they don’t plough resources back into developing their oil reserves. Added to this there is a likelihood that new exploration and field technology will start to increase production at the same time as Western demand declines. Then excitement of “Peak Oil” will fade for the time being. 

In the case of Metals, there are longer term issues. It takes considerably longer to increase mining production in the short term and there is much less politically shut in capacity compared with oil. In the case of mining, the potential for increasing production of current mines is, in many areas, considerably reduced by a shortage of electricity generating capacity. South Africa being a case in point, recently in the News. 

Looking at the world as we go into the Dog Days of summer, the most worrying wild cards, apart from the continuing financial explosions, are the edgy politically situations. In America the election will continue to produce irrational politics. In China there are many malign forces who would like to disrupt the Olympics, which could produce unforeseeable and damaging political consequences around the world. It is also not clear how serious Russian sabre-rattling is along the East/West border. This particular problem is exacerbated by the somewhat incoherent European-wide foreign policy; or rather one should say the inability to create any cohesive policy. 

If we can get through the current year-end without a political accident adding to the economic problems, then certainly by the middle of 2009 actual economic conditions should be improving. The improvement will, of course, not be visible in the Press as many of the statistical indicators will by then have been pointing downwards for nearly two years, since the middle of 2007. 

Best wishes for the summer.

Damon de Laszlo 
July 2008

DABERIAM XL

June 2008

The Chairman of the British Financial Services Authority made a stunning statement to the Annual Conference of the British Bankers Association: The FSA will press ahead with plans to overhaul the regulation of banks’ liquidity requirements even if international efforts to co-ordinate a response to the credit crisis are delayed - from the Financial Times, 12th June. 

Bearing in mind it is the FSA’s lack of attention or comprehension of bank regulation which allowed the Northern Rock situation to develop and the inadequacy of the Basle 2 Rules to create an international liquidity standard for banks that has allowed the rapid spread of the banking crisis around the Western world, one can only be amazed at the hubris of the regulators. 

Political pressure is tending to give Regulators the power to introduce national standards in a global world. It is also giving politicians the misplaced confidence that comes with 20:20 hindsight to add to the confusion of regulation.

The last ten years, with its ups and downs, have been basically benign from an inflation point of view. This environment has been largely due to the growth of global trade and the impact of Chinese industrial development, which has kept down the price of manufactured goods. This low inflationary period has ended as the supply of raw materials, i.e. oil and other energy sources, copper, iron, etc. has been overrun by demand, dramatically pushing up their prices, with its knock on effect on food and other basics. During the year domestic inflation in China has started to rise sharply. To the rising raw material prices must be added rapidly rising wage rates as labour shortages start to appear in the areas where the earlier industrialisation took place. To the rising domestic prices must be added the currency appreciation of the RMB being caused by the huge balance of trade surpluses. Chinese goods are now adding to western inflation rather than restraining it. 

Global Economic Indicators

World Economic Growth	2007 (IMF Estimate)	4.90%	2006 (World Bank)	4.00%	2005 (World Bank)	3.60%
Base rates: 30 May 2008	USD	2.00%	EUR	4.00%	GBP	5.00%
MSCI World Equity Index	30/05/2008	323.824	31/12/2007	299.916	YTD %	7.97%
Gold (PM London Fix $ per ounce)	30/05/2008	885.75	28/12/2007	833.75	YTD %	6.24%
Oil (WTI Crude $ per barrel)	30/05/2008	127.36	28/12/2007	96.01	YTD %	32.65%

The conventional Central Banking response to inflation is to push up interest rates to dampen down the economy, but this will have little effect on imported inflation. Coincidentally, there is a massive restriction in liquidity arising from the banking crisis as well as being imposed by the Regulators. 

The combined effect of these policies is likely to drive the economies of Europe and the UK into a major downturn as national Governments in these areas consume some 50% of their respective countries’ GDP, the ability of the rest of the economy to react to the changes is limited. So we can expect recession and inflation. 

The good news for Asia is that the slowdown is from fast to not quite so fast economic development as domestic demand is somewhat perversely replacing export demand as national wages rise. The beneficiary of development apart from Asia is primarily the USA, which is becoming the new supplier to the world as US industry takes advantage of the dollar depreciation. 

While the US banking and property crisis will cause considerable economic disruption, the industrial revival will create a considerable cushion to the general downturn. It is particularly important to remember that the US Government represents the cost of only some 25% of the country’s GDP compared with Europe. 

Commodity prices in general will probably reduce as the world economy slows but oil and other energy sources are constrained by political action in the producer countries with surplus capacity. While wind and solar are nice but minor sources of energy, the other source, Nuclear, again is constrained by politics. 

It is unlikely, therefore, that we will head into a major global recession and maybe the fact that Europe suffers most in the global context will show people that the overarching European bureaucracy is the problem, not the solution to our prosperity. However, my thought for the summer - this is more of a hope than a likelihood - is that the politicians can’t fool all of the people all of the time. We will see what the summer brings.

Damon de Laszlo 
June 2008